From Defense to Offense – Earnings Growth Re-accelerating

 In Quarterly Update

After 13 months, the corporate profit recession appears over

A year ago the global economy began its long awaited corporate profits recession and along with it came a period of significant volatility, during which time some sectors of the market and many individual stocks fell dramatically. The last time we witnessed a deceleration of corporate profits was the memorable year of 2008. However, as we have described during the past year, this period has been much different – thankfully – than past recessions in terms of market reaction. Though many sectors fell to “bear market” levels over the past 13 months (think energy, materials, tech, and financials) they never did so all at once.  This made for what we called a “teddy bear” market as opposed to the “grizzly bear” we witnessed in 2008 and most of the previous recessions throughout history. The important question for investors today is whether this period of unstable profits and market vulnerability is over? And if so, what should investors do?

Our research suggests that the recession and “teddy bear” market of 2015-16 may be over. After more than a year of companies slowing or altogether halting production we are now seeing “green shoots” of increased production.  This can be seen throughout most of the sectors where some of the biggest stock declines occurred over the past 13 months and in individual companies such as Apple that have recently increased production once again.  In many ways this has been a textbook corporate profit recession in terms of companies experiencing slower sales, which in turn caused slower or halted production and stock prices faring poorly.  However, once product inventory reaches bare levels – where we are now – production starts once again and the business cycle begins anew in earnest. As stock investors, this is the time to change your portfolio to be more growth oriented and take advantage of a re-acceleration in earnings growth – and equity prices – particularly in the sectors where the most value exists, such as the aforementioned materials, energy, tech and financials.

We know that the media suggests that the market is in a bubble and that many investors fear that the worst is yet to come for stock prices.  In fact, many suggest that we have another 2008 around the corner.  Though no one knows for sure – hence our use of risk management tools – there is a pile of evidence that suggests that the opposite is likely.  First and foremost, 2008 was caused by an overdue corporate profits recession, a significantly over valued market, and a financial crisis unlike anything seen since the great depression.   Unlike the recent “teddy” bear market, in 2008 we had a consumer recession paired with a corporate profits recession, which sent stock prices tumbling all at once in a violent and catastrophic decline.  This time around consumer spending has held up, there is more demand for housing than supply and stock prices were never way overvalued.  Moreover, the recession in earnings is closer to its end, as opposed to its beginning, and some sectors are downright undervalued.  Lastly, we find of interest the preponderance of negative news about an impending market collapse. At no time in history has a big decline in markets come with such overwhelming warning – the big declines come when no one expects them.

Most global stock indexes have been trading sideways since the end of 2014 and are now just slightly (~2%) above their all-time high. We think that investors should prepare for the beginning of a new business cycle and invest where the growth can be harnessed.  As you have probably noticed, in recent months we have been making your portfolio more growth oriented and we are optimistic about the great companies and future profitability of the companies we have added to your portfolio.

In terms of fixed income, investors should prepare themselves for higher interest rates. The Federal Reserve has every intention of continually increasing interest rates and the resurgence of corporate profits will make this an easy task. This will eventually create higher yielding bonds and better value in the bond market.  However, as rates rise, this will have a negative impact on intermediate and long term bond prices and bond funds.  We have steered clear of these investments in your portfolio and suggest other investors take similar precautions.

As we have reiterated many times – corporate profit recessions come about every 7-9 years and this one was right on time.  They also last 12-18 months and this was around 15 months old.  We look forward to a more constructive stock market going forward and reaping the rewards of an upturn in profits.  However, in case we are early in our bullish strategy, we are prepared to retreat and protect your portfolio through our Active Risk Management process.  This involves your portfolio’s allocation to stock, your sector exposure and the use of carefully placed stop loss orders.

We hope you find this update helpful and if you would like to discuss your portfolio, or have experienced a significant change in your financial affairs, please let us know.  Once again, from all of us, thank you for your continued vote of confidence in our work. If you have any friends or colleagues who you feel may benefit from our services, we would be happy to introduce ourselves to them with a no-obligation introductory meeting.